The U.S. has failed to fix the problems of its banking system, notes Joseph Stiglitz, the Nobel Prize-winning economist. The “too-big-to-fail banks” have become even bigger; the problems are worse than they were in 2007 before the crisis, he told a reporter on Sept. 11 (or thereabouts).

Chinese stockpiling of commodities could taper off and remove a prop supporting commodity prices.

U.S. tariffs on Chinese tires and China’s likely retaliation in the form of tariffs on U.S. chickens and car parts could signal the start of a trade war; the longer China and U.S. refuse to take a co-operative approach to addressing lingering structural imbalances in the world economy (i.e. undervalued yuan and unbalanced growth), the more they risk failing to achieve a sustainable recovery.

U.S. bank credit continues to contract at an alarming rate, down $200 billion since the end of July to the beginning of September. Credit deterioration tends to lag but the annualized drop of 12% over the past 13-weeks has been unprecedented. “The credit system is still … broken,” writes David Rosenberg of Gluskin Sheff.

Loan-loss provisions at banks are piling up and likely to get worse according to Moody’s.

I hate to post another downbeat entry after yesterdays’ post but I just came across some publications from the Bank for International Settlements, an organization that serves as a bank to central banks. I assume they have a little more substance than the usual lot of permabears and professional doomsters, so when their staff issue documents (Annual Report and working papers) with a tone that reminds one of the bearish sentiments of David Rosenberg, it seems worth noting for active investors (less so for passive).

What concerns BIS? They worry that the bank bailouts have left behind some unfinished business, and a failure to deal with it endangers the economic recovery. As the Annual Report notes:

“The policy response did succeed in averting the collapse of the financial system and in calming the markets. It was less successful, however, in convincingly addressing the impaired assets on banks’ balance sheets …. A significant risk is therefore that the current stimulus will lead only to a temporary pickup in growth, followed by protracted stagnation.”

The BIS says banks around the world were bailed out with no rigorous conditions for booking losses, disposing of bad assets, and eliminating excess capacity. As a result, “doubts about the long-term health of major global banks remain, with uncertainty about the potential losses from loan books and other credit exposures” adversely affecting the banks’ ability to raise capital.

Asset purchase plans were announced but little action seems to have been taken in most countries. One exception was the Swiss National Bank, which bought mortgage-related assets from UBS and placed them in a special investment vehicle. In the U.S. and Germany, things are on the quiet side.

“The lack of progress on removing troubled assets from the banks’ balance sheets and recognizing the associated losses is illustrated by the US experience. Rather than buy impaired assets directly, the US Treasury outlined a plan in March, the Public-Private Investment Program (PPIP), to value these assets and to remove them through an auction mechanism …. Despite the favourable terms … the outlook for the PPIP [remains] uncertain [recent Chinese interest notwithstanding]”

According to BIS:

“The steps taken so far have focused largely on providing guarantees and subsidized capital. At the same time, government guarantees and asset insurance have exposed taxpayers to potentially large losses. Progress on problem assets has been slowed by the complexity of the securities affected, legal constraints and, above all, the limited political will to commit public funds to the clean-up effort. The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy.”

Continues BIS:

“What seems clear is that the deterioration in credit quality will generate more losses on banks’ loan books and other credit exposures. Banks may therefore have an incentive to delay recognizing losses, aided by accounting rules that provide management more discretion over when to write down assets. Taxpayers will not want to be exposed to greater potential losses, but key financial institutions are likely to require more government support in order to facilitate the required adjustments, to restore confidence in the financial system and to restart lending on a sustainable basis.”

Governments could have made a timely clean-up of balance sheets a condition of injecting funds but they lost some of their leverage when most decided to purchase hybrid securities such as preferred shares instead of common shares. Preferred shares limit the risk of loss to the taxpayer while providing a more attractive dividend stream than common shares. These benefits come at a cost because preferred shareholders typically cannot vote at shareholder meetings, which constrain their ability to influence management.

As a consequence, BIS worries that the massive fiscal stimulus packages may lead only to a transitory uptick. “Short-term actions that delay adjustment and prop up aggregate demand may not be compatible with the medium-term need for banks to de-leverage their balance sheets so as to lay the basis for a healthy financial system and a self-sustaining recovery.”

Two other things about the banks bailouts are disconcerting to BIS. First, the rescue of banks deemed too big to fail has heightened the moral hazard problem, i.e. aggressive risk taking is encouraged because bankers assume the government will always step in to save them. Second, “the rescue packages and government-directed sales of failed banks may unwittingly increase systemic risk by creating larger financial institutions.”

Well, that hypothesis got a good testing with the current bear market. Did the Claymore ETF live up to the billing? As it turns out, both ETFs ended up showing the same drop of about -22% over the two-year period ending July 6 – see the Yahoo chart below.

For the first 14 months to September of 2008, the iShares ETF was ahead. But then it collapsed big time in October and the two ETFs were neck and neck. As the bear market deepened, the Claymore began falling behind again – contrary to what would be expected it would seem. Then, during the vigorous rally from March, 2009 onward, it rose faster and pulled up even with the iShares – again something not aligned with expectations.

It would seem the explanation for these movements is that fundamental weighting gives more emphasis to the financial sector. So the extreme volatility caused by the crisis of confidence in this sector may be what kept the Claymore from performing according to the hypothesis. Perhaps if the bear market was more like past bear markets, i.e. without a grave financial crisis, the Claymore would have done better.

A comparison of the Claymore and iShares ETFs tracking U.S. and global stock markets resulted in a split decision. Claymore came out ahead in the global space and iShares in the U.S.

One caveat: these comparisons were done on a price basis only. Ideally, distributions should be included and the comparisons done on total-return basis. At the moment, for example, the estimated yield on the iShares comes out somewhat ahead, at 3.1% vs. 2.6% for the Claymore. If this spread persisted over the two years, then the iShares would be slightly ahead at the end of the period.

Another caveat: different time periods can give different results. For example, if we just look at the year ending July 6, 2009, CRQ was the winner, declining bout -15% compared to about -25% for XIU. So, within that time frame the thesis did hold up.

Regulation does have a role to play in achieving that objective but we must not lose sight of other factors and measures that go more directly to the heart of the matter. That is to say, at ground zero in this whole mess is a huge set of imbalances in the world economy; to get out of the bubble-and-bust pattern that has settled in during the past decade, these disequilibria must be corrected.

And so far, there aren’t any good indications of such. That is not a good omen. One can have the best regulatory system in place but it will be like a sieve if the structural imbalances in the economy are not turned down.

The chief imbalance manifests most directly as a chronic deficit in the U.S. balance of trade, which has in recent years stood at about 6% of GDP. That means, as a nation, the U.S. is consuming and investing 6% more than it’s producing. Ordinarily, such an imbalance does not persist for very long – market forces would drive consumption lower in the deficit country and drive it higher in the surplus country.

But those market forces are not being allowed to operate. Many countries in the world, notably Asian countries such as China, are pursuing industrialization strategies based on export-led growth and are suppressing the value of their currencies against the U.S. dollar. They need to de-emphasize such export-led growth in favor of domestic-led growth. As well, they need to allow their currencies to appreciate against the U.S. dollar (or, on the flip side, let the U.S. dollar fall against their currency).

As for the U.S., its spendthrift ways need to be dialed down to get national spending more in line with production. By some combination of measures, the rate of internal savings needs to be raised. This starts with, as former Fed chairman Paul Volker says, “a strong sense of monetary and fiscal discipline.”

There are no signs of such discipline at present. Indeed, U.S. monetary and fiscal policies are set to accommodative extremes not seen since World War II. Now that the risk of financial collapse has subsided, they should be reined back. This may trigger stagnation for a time but that is not to be feared. The U.S. is not Japan; it is a deficit country whereas Japan is a surplus country. Japan needs to stimulate its economy more, the U.S. less.

Living within its means is what the U.S. has to do to bring about a sustainable solution to the imbalances that are generating grave disequilibria. Just as good, it will put pressure on trading partners to abandon their export-led industrializations in favor of domestic-led industrializations — because if the U.S. is living within its means, it won’t be buying as many exports from other countries. For more thoughts on this theme, see the article, Averting Armageddon.

Highlights include Dominique Strauss-Kahn, managing director of the International Monetary Fund, scolding leaders of the developed countries for promising to cleanse the balance sheets of their financial institutions with some haste, and then (to his mind) dragging their heels. He went so far as to say they’d done nothing—an overstatement he rather quickly retracted. But he stuck to his guns that the process of getting the toxic assets out in the open was “much too slow… There are lots of losses that have so far not been exposed.” (The IMF puts “lots” at about $500 billion.”)

Something of a debate that emerged in the forums this morning was the question of why, if “the worst of the banking crisis is behind us” (a phrase tossed about repeatedly), credit flows remain impaired. In other words, if the banks really are on a sounder footing again, why don’t they start doing their job and lend more money?

The most lucid answer came from Jan Hatzius, chief US economist for Goldman Sachs. (Hatzius was among the few economists to correctly call the widespread effects of the US housing bust.) His reply to the question of impaired credit flows? Lack of demand.

Banks are not lending money because the private sector is not borrowing it. For instance, U.S. consumer spending in the second half of ‘08 fell by 4%—a huge drop in a short period of time. Consumer borrowing is falling and the U.S. savings rate, which had been negative for years, is positive and rising. So it’s not that there isn’t money to borrow anymore. Lack of credit supply was a “2007/08 issue,” Hatzius said. “Demand for credit is an ‘09 issue.”

Hatzius, who by the way came out on top of the Wall Street Journal’s economic forecaster rankings for ‘08, was more upbeat (in his way) about the US dollar. He said that he thinks concern over a “deluge of debt” undermining the U.S. Treasury is “overblown.” He pointed out that the US trade deficit has shrunk sharply in a very short period of time, so effectively private sector savings are funding the debt expansion in the States.

The economist was downright upbeat about Asia, however. When it comes to China, Hatzius said he tends not to rely on statistics solely out of China as they are hard to decipher or rely upon, but he does look at other Asian economies, like Korea’s. And “there’s no question that the Asian countries are coming back.” He suggested, in fact, that a classic V-shaped recovery is occurring in Asia right now, even as the West is waiting for the recovery to start.

Look for that around the end of the year…

Calgary is no longer leading the trend downward. That honour now belongs to Vancouver, which dropped 9.6%. Next came Calgary (−8.4%), Toronto (−6.9%) and Halifax (−0.8%). Just two cities managed to stay in positive territory: Montreal (2.9%) and Ottawa (1.0%).

All cities in the index are down from their peak levels. Calgary, Vancouver and Toronto are off their peaks by more than 10%.  This is beginning to look like a U.S.-style retrenchment — only with a lag of 12 to 18 months. For more detail, see the charts ( from housepriceindex.ca) below.

Much has been made of the resiliency of Canadian banks in the midst of the global financial meltdown. But was it, in part, based on a delayed tumble in house prices? Now that the Canadian market is beginning to resemble the U.S. market, will Canadian banks be able to keep a stiff upper lip?

National level

Francis Chou, manager of Toronto-based Chou Funds, has in the past not been a fan of financial stocks. During a previous rally, he warned unitholders to stay away from them because of the DROP principle (D is for dribbling out the bad news slowly, R is for raising money, and OP is for dishing out the most optimistic projections). “Once the money has been raised from investors, these companies will announce a few months later ‘the big drop’ – that is, to take a big writedown,” he wrote.

Chou is not as negative on the current rally in bank stocks. When he coined the DROP principle during a previous rally, he “was trying to alert unitholders to the dangers of toxic assets in the balance sheets of financial companies. They were not written down and the financial companies may try to raise capital before they had to declare the true extent of their losses in toxic assets ….That is not applicable now because of the cataclysmic losses they reported in 2008.”

He adds: “Banks that have not been affected by the financial crisis will do quite well in the future. With the governments driving the treasuries to yield nearly 0%, the spread between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. For the first time in many years, banks are being paid handsomely for the risks they are taking.”

Which banks have come through the crisis relatively unscathed? Royal Bank of Canada and other Canadian banks have. In the U.S., big banks that got through the crisis without government funds were (according to an IMF chart in this document):

JP Morgan Chase (JPM)
Wells Fargo (WFC)
US Bancorp (USB)

When you are not too big to fail, you are … well, allowed to fail. The Federal Deposit Insurance Corp. closes your doors. So the list of failed regional banks keeps growing. According to the FDIC, there were three banks shuttered in 2007, another 25 in 2008, and 32 more in just the first 18 weeks of 2009.

As the list gets longer, warns the May 20 issue of Standard and Poor’s The Outlook, it could have negative consequences for investors in smaller banks — specifically, holders of exchange-traded funds such as the iShares Dow Jones US Regional Banks (IAT) and SPDR KBW Regional Banking (KRE).

I have said before that eventually things will get back to normal. Maybe it’s just incurable optimism on my part. But that doesn’t rule out some volatility in the meantime. Narayanan writes:

“Unfortunately for the Fed, were a recovery to materialize, the bond markets should suffer forcing the Fed to more quantitative easing. And were the economy to weaken, the fiscal deficits are going to increase further demanding even more quantitative easing. This makes the Fed largely powerless in the current situation – its policies of dollar printing are here to stay in most reasonable scenarios for the economy. When the markets realize this, we should enter the next leg of this unfinished crisis.”

What he means by “the bond markets would suffer,” is that if the economic recovery shows more signs of taking root, government bond yields will ratchet up. Since the rising yields will endanger the recovery — as I discussed in a previous post – the Fed will have to print more money to buy up Treasuries and hammer their yields back down.

Where Narayanan extends the analysis for me is that even if the economy doesn’t pull out of recession, fiscal deficits will get even wider and require the Fed to buy up more government bonds than presently expected. This, of course, will require more money to be printed.

So, regardless of the economy’s direction, the Fed may be driven into more quantitative easing — and this could be unsettling to the market when it catches on. As he outlines in his latest commentary, Narayanan seems to think the most likely scenario is that the economic recovery will falter: “A slowdown in the U.S. will trigger even more government expenditure and more quantitative easing by the Fed – actions that will increase the risks of a dollar and/or a bond market crisis.”

Narayanan’s investment performance:

iShares Dow Jones US Financial Sector (IYF) 71%
Financial Select Sector SPDR (XLF) 99%
Regional Bank HOLDRs (RKH) 128%
Rydex 2x S&P Select Sector Financial (RFL) 238%
Direxion Financial Bull 3X Shares (FAS) 325%

The U.S. financial sector could add to these gains but longer term it’s not obvious to me it is a sector to which one would want to give a lot of weight in their portfolio. There are two main reasons why.

First, those business models that gushed earnings during the boom era seem somewhat busted now. It’s difficult to see many of their tainted product lines, such as asset-backed securities, regaining the popularity they once enjoyed. Moreover, legislators will likely bring in regulations to tame financial innovation and temper other aggressive practices. And regulators will probably be a lot less tolerant of non-compliance. Finally, the Federal Reserve has learned that it needs to keep not only consumer prices under control but also asset prices — so once the economy has climbed out of its current hole, monetary policy should be run more conservatively (which means less credit creation for the banks).

Second, even if the above analysis ended up wrong, I still would not want to have anything to do with the big financial conglomerates in their present form. Another argument for avoiding them is one that believers in socially responsible investing (SRI) may be able to identify with. SRI abstains from investing in companies that harm society, the classic example being tobacco companies. I would add to that list many of the big financial conglomerates.

They unleashed a severe financial crisis and recession on the world. What immense harm they have caused — and could do again if they are allowed again to operate unfettered. Not only that, but look at the trillions of dollars taxpayers had to give to them. They have socialized the losses and privatized the gains.  I personally would find it repugnant to invest in their shares.

The sustainability of the U.S economy requires a halt to the relentless climb in indebtedness, if not a lengthy period of deleveraging. Investing in the big financials would only lend support to unhealthy trends. The pusher has to stop selling his drugs to the addicts.

His February report to unit holders augments some points I was making in my column last week on the U.S. government deficit. Specifically, he warns that the U.S. budget is addressing too many issues at once.

Washington is attempting to deal with “the aftermath of the crisis while at the same time attempting to build a framework for sustainable growth through investments in alternative energy, healthcare and the like.” This will push the U.S. into a deficit-spending cycle “which could backfire badly,” Narayanan says.

At a projected $1.75 trillion, the U.S. deficit for 2009 far exceeds the U.S. domestic savings rate and is larger than the combined surplus savings of the rest of the world. Along with previous requirements for bond issuance, the U.S. is expected to float well over $2 trillion in Treasury securities in 2009.

“If the world balks at purchasing the huge quantity of Treasuries issued, we could have a bond market crisis with U.S. yields spiking dramatically. If the Federal Reserve were to step in to monetize the debt by printing U.S. dollars, it would be a Zimbabwe-style response to the problem and could trigger a currency-market crisis,” adds Narayanan.

To minimize this risk, U.S. politicians should get agreement from rest of the world on how to finance the huge expenditures that are planned. But such support does not seem likely. Indeed, both Europeans and the Chinese are sounding rather unforgiving in their pronouncements on the situation in the U.S.

“Such dissent does not bode well for financial stability going forward,” concludes Narayanan. “We are very likely setting the stage for a significant bond market crisis this year.”

Stress tests may have some teeth after all

Krishna Guha, Financial Times of London
“A Fed white paper on the tests revealed that regulators ignored recent changes that water down mark-to-market accounting rules when assessing how much of a capital buffer each bank needs to ensure that it could comfortably survive a deeper recession than expected.
This is likely to result in some banks having to raise more equity than they would have done if the new accounting guidance had been applied, resulting in a stronger capital buffer but also greater dilution for existing shareholders. Regulators also took an expansive view of the risks banks need to hold capital against, including off-balance-sheet exposures and counterparty credit risks.”

Insiders dumping shares

Michael Tsang and Eric Martin, Bloomberg news
“Executives and insiders at U.S. companies are taking advantage of the steepest stock market gains since 1938 to unload shares at the fastest pace since the start of the bear market”

The coming tidal wave of corporate bond defaults

Floyd Norris, New York Times
“So it went with the subprime mortgage crisis. And so it is now going with corporate loans and bonds. It appears that defaults on leveraged loans and corporate bonds will soon rise to levels not seen since the Great Depression …. One reason for the rise in defaults is that this is a severe recession. But it is not the principal one. Junk, circa 2009, is the worst junk ever …. Calculations by Moody’s Investors Service show that as of the beginning of April, a record 27 percent of speculative-grade debt issuers had a rating on their senior debt ranging from Caa down to C.”

Banks getting the wrong medicine

Daniel Hofmann, chief economist at Zurich Insurance Co.
“… big, troubled U.S. banks represent a large part of that country’s economic woes, but are being given the wrong medicine … The problem …is that the U.S. government has been treating banks as if they had a liquidity problem, while in fact they have a solvency problem …. The two problems are very different: you need liquidity if you owe $100 tomorrow, but your only asset is a $100 item that will take a week to sell. All you need is a short-term loan …. But if you owe $100 tomorrow and your sole asset is worth just $50, you have a solvency problem ….Those who see a solvency problem don’t believe that all the U.S. plans to create a market for bad bank assets will work. These plans assume that the assets have significant value and buyers just need some encouragement …. But if the assets are worth very little, some big banks are insolvent. Then, the only cure is to close them, let their investors and lenders take a loss and peddle the assets for whatever they’re worth …. If that’s the case, the longer government waits to administer this bitter medicine, the longer the U.S. will have a hobbled banking system and substandard growth.”

Retest of March low coming?

Mark Hulbert, MarketWatch
“… new bull markets often retest the lows of the bear markets that preceded them. That means that, even if a new bull market is now underway, it is not necessarily essential that you immediately increase your equity exposure …. Consider what happened after the 2000-2002 bear market came to an end on Oct. 9, 2002 .. The bottom line? Even if the train has left the station, there’s still a good chance that it will return to pick up more passengers.”

The first sentence goes: “Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized.” Really? Maybe someone can help me here. I got the impression from an April 21 piece in the LEX column of the Financial Times of London that there was a bit of a shortfall. It says:

“McKinsey estimates that US banks still hold about $2,000bn in impaired assets. By comparison, the Federal Deposit Insurance Corporation estimated that US banks had tier one capital at year-end of just $1,296bn. That $700bn gap is simply too big to be breached by earnings power.”

Could one reason for the discrepancy be due to different approaches to valuing loan portfolios — with SCAP using the banks’ convention of carrying them at amortized cost instead of mark-to-market? As the white paper states:

“Loans held in portfolio subject to accrual accounting are carried at amortized cost, net of an allowance for loan losses. The use of accrual accounting for these assets is based on BHCs’ intent and ability to hold these loans to maturity, which reflects, in part, a combination of more stable deposit funding and information advantages about the quality of the loans they underwrite. The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices ….”

Oh, wait a minute. Reading down further, the white paper does admit the banks do need capital after all. It’s needed because the economy is going to get worse and present capital bases may not be able to cope with the expected loan losses:

“Given the heightened uncertainty around the future course of the U.S. economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies (BHCs) to hold additional capital to provide a buffer against higher losses than generally expected, and still remain sufficiently capitalized at over the next two years and able to lend to creditworthy borrowers should such loses materialize.”

The government stands ready to help out:

“The United States Treasury has committed to make capital available to eligible BHCs through the Capital Assistance Program as described in the Term Sheet released on February 25. In addition, BHCs can also apply to Treasury to exchange their existing Capital Purchase Program preferred stock to help meet their buffer requirement.”

On page 4 we are given some detail on how the data for the estimates were collected:

“The BHCs (bank holding companies) were asked to estimate their potential losses on loans, securities, and trading positions, as well as pre-provision net revenue (PPNR) and the resources available from the allowance for loan and lease losses (ALLL) under two alternative macroeconomic scenarios.”

I must admit my initial reaction was similar to Professor Robert Salmon’s. In his words:

“So if I understand this correctly, the Treasury is relying on banks to provide them with an assessment of their current troubles. This is like asking an alcoholic if he thinks he has a problem.”

We also get detail on the parameters used in the baseline and adverse scenarios projected for 2009 and 2010. These are already well known and many observers have commented that developments in the economy now suggest the adverse scenario would have been more fitting to use as the baseline scenario.

The stock market’s reaction was interesting. It seemed a little uncertain how to interpret the report. There was an initial dip on the news, followed by a rally. Then near the close, there was a rather sharp drop — but not enough to wipe out the day’s gain. Bad omen that last bout of selling? Last Friday, as I recall, there was a similar finish to the trading day and Monday ended decidedly down.

To see the Federal Reserve white paper, click here.

But what a wall or worry it is this time. Did those buying really do their due diligence and check the fundamentals carefully? Or are they simply letting Mr. Market tell them it’s the time for climbing the wall of worry? Or worse, are they caught up in a buyer’s panic and motivated by the fear of being left behind?

These were the questions that came to mind when I found some more time to resume the mash-up of highlights from the stream of data/commentary on the current/future state of the economy and financial markets. When you step back a bit and listen to some other voices besides Mr. Market’s, there seems to be a rather wide disconnect between the two.

What follows pertains to just the financial sector, which has been mainly responsible for the stock-market rally in the U.S. I hope to cover other aspects in subsequent posts.

Highlights from the data/comments flow

Green shoots are appearing and we will be watching for more signals that will herald the economic recovery. For now, it is not self-sustaining economic growth yet. Stability in the financial sector, with clean balance sheets of banks and a working credit machine, will be necessary for self-sustaining economic growth. Northern Trust economists.

Some of the largest mortgage companies are stepping up foreclosures … [they] had stopped foreclosing on borrowers as they waited for details of the Obama administration’s housing-rescue plan [and for other reasons] … now, they have begun to determine which troubled borrowers … to move through the foreclosure process …. The resulting increase in the supply of foreclosed homes could further depress home prices and put additional pressure on bank earnings as troubled loans are written off. Wall Street Journal.

U.S. foreclosure activity was up 46 percent in March from a year earlier, hitting a record high as programs stunting the torrid pace of failing mortgages expired. RealtyTrac.

More than 2.1 million homes will be foreclosed in 2009, up from about 1.7 million in 2008.Economy.com.

Credit offered by the 21 largest banks receiving TARP funds fell 2.2% in February compared with the prior month. U.S. Treasury Department.

Like the other US banks that reported first-quarter earnings this week, Citigroup was desperate to appear as healthy as possible ahead of the Treasury’s stress test results, which are now just weeks away …. But Citi will have $80B of tangible equity versus assets of $2,000B … that is still worryingly geared. LEX, Financial Times of London.

It does not help that many banks have not set aside enough reserves for credit losses –Wells Fargo holds an array of assets at rose-tinted values and may need another $25 billion in capital on top of the $25 billion it has already taken from the Treasury. Few banks hold their commercial-property portfolios anywhere close to 50-60 cents on the dollar. Economist magazine.

The banks will face more pressure because their legacy loans have not been marked to market …losses on the banks’ loan portfolio are likely to rise to 3.5% by the end of 2010, which would exceed Depression Era losses … the banks aren’t factoring those losses in yet. Mike Mayo banking analyst for Calyon Securities.

The banks will not see profits after the first quarter … home prices will fall another 30%. banking analyst Meredith Whitney

Home prices will fall 22% to 27% from their January levels. Ronald Temple, a director of research at Lazard Asset Management.

The negative dynamics between the real and financial sides of the economy have created severe downside risks … [financial markets remain highly stressed, making them an impediment to recovery] …While we’ve seen some tentative signs of improvement in the economic data very recently, it’s still impossible to know how deep the contraction will ultimately be. Janet Yellen, president of the San Francisco Federal Reserve.

My latest estimates are $3.6-trillion in losses for loans and securities issued by U.S. institutions …. It is said that the International Monetary Fund will announce a new estimate of $3.1-trillion for U.S. assets … By this standard, many U.S. and foreign banks are effectively insolvent …. Nouriel Roubini, Professor of economics at the Stern School of Business.

The Obama plan to fix the banking system is destined to fail … The people who designed the plans are either in the pocket of the banks or they’re incompetent …. TARP isn’t large enough to recapitalize the banking system … weaker banks should be put through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders. Nobel prize economist Joseph Sitglitz

More representative of the state of the banking system arguably is Capital One Financial, which reported late Wednesday a surge in credit-card losses in March, to 9.33% from 8.06% just a month earlier. Randall W. Forsyth in Barron’s

Financial stocks leading this rally have run 26% above their 50-day averages — the widest gap in almost two decades. Kopin Tan in Barron’s

More blows are coming. Banks worldwide have written down their assets by $1.1 trillion. The final tally is expected to be double that, or more. The pain is only now starting to spread through commercial property and commercial loans. As a result, the first-quarter reprieve will turn out to be a “head fake”, says Chris Whalen of Institutional Risk Analytics. Economist magazine.

When the bill came due during the 1970s for the guns and butter policies of the 1960s (Vietnam War and Great Society programs), the result was a roller coaster ride in the economy, accompanied by a steady ratcheting up of inflation. Will the bailout similarly lead to a decade-long period of painful adjustment?

What’s perhaps a bit different this time around is that emerging nations are more industrialized and keen to continue growing. So they may absorb a great chunk of the U.S. government debt in order to keep their currency cheap and exports flowing. In that case, the consequence would be further  deindustrialization of the U.S. and even greater dependency on them for its standard of living.

I see so many articles and books questioning capitalism and free markets these days, when the real problem, in my opinion, is that capitalism and free markets capitulated to rent-seeking behavior over the decades and became sclerotic from allowing domestic monopolies and cartels to take root. Consequently, the developed economies became less competitive.

The U.S. auto companies were once a cozy cartel. They lost that position many years ago, but their unions still had monopoly control over labor markets and maintained the uncompetitive status quo. To insist on more change in the auto industry, especially in the area of labor costs, would seem to be the right step forward.

Unfortunately, the auto sector is just one small part of a systemic problem. The misallocation of resources within developed economies remains pervasive thanks to the widespread suppression of free markets. Many of these concentrations of market power have been with us for so long that we don’t seem to see them anymore. I’ve hammered on some of them before. Here are a few choice case studies:

The real estate cartel: If it looks like a duck, quack like a duck …

School for thought: Some think tanks are asking important questions about the public school system.

Lawyers: Another conspiracy against the laity? The common law system is too complex and costly — let’s fix it.

Milking the Canadian consumer: It’s time to get rid of the dairy industry’s government-backed protection.

No doubt when one complains about vested interests, the complainer’s comments basket is likely to fill up with scathing denunciations from denizens of such vested interests. If that’s the price for saying it like it is, then so be it. I just hope other, more objective readers realize where those commentators are coming from.

First, AIG International Group recently handed out more than $200 million in bonuses to executives even though it has received a $170-billion bailout from the U.S. Government and previously had a run-in with regulators over bonuses. The U.S. Senate wants to claw back AIG’s latest bonus extravaganza through taxation. But this doesn’t go far enough, in my opinion. Bonuses are a systemic problem that keeps popping up, again and again. Politicians and regulators should really be thinking about clawing back bonuses for all firms that contributed to the financial crisis and retroactively to 2007 at least — for reasons laid out in my Sept. 11 2008 column, Claw back the bankers’ bonuses.

Second, while bonus-driven bank executives were laying the groundwork for today’s financial implosion, legions of bank lawyers and accountants were busy exploiting loopholes to cut tax bills for the banks and their high net-worth clients. So while taxpayers are now being asked to pay for a trillion-dollar bailout of the banks, they also got the short end of the stick when times were good.

This week, a whistleblower released internal memos from Barclays Bank revealing “the process involved in structuring extremely complex and artificial tax avoidance schemes,” to quote the editor of the Guardian newspaper (which had posted the documents on its website until a court ordered them to be removed). One scheme, wrote Hugo Dixon in breakingviews.com, “aimed to save tax by shunting over $16bn of loans from a series of companies and partnerships in the Cayman Islands and Luxemburg.”

Last month, tax avoidance by other financial institutions made the headlines. Swiss bank UBS AG, which was under investigation for allegedly helping 17,000 American citizens to evade taxes, agreed on Feb. 18 (thanks to an order from Swiss regulators) to provide the U.S. government with the identities of over 200 American clients and to pay $780 million in fines and restitution.

Another step toward reining in the financial sector is to address tax avoidance. Cleaning up the mess they left behind is going to cost a lot and every source of revenue needs to be tapped. Why should the banks be allowed to conitnue dodging taxes for themselves and their clients when trillions of dollars are needed to stabilize the system?

So close the tax loopholes. Make it unlawful for the banks to have subsidiaries or affiliates in tax havens. And, as Dixon said, adopt globally the U.S. doctrine of “economic substance,” under which transactions need to have some genuine purpose other than to avoid taxes.

Lastly, as Dixon also suggested, recruit better tax inspectors. So far, they have been no match for executives motivated by million-dollar bonuses. What, then, if we give the tax inspectors bonuses too? Make the reward a percentage of the taxes recovered. That’ll work for sure.

While the blog will focus mainly on Canadian issues, I’ll discuss relevant American initiatives as well, since most economists agree that this country’s fortunes depend on how the U.S. deals with its economic setbacks.

Look for short posts linking to commentary on other writers’ blogs, quick hits like the “quote of the day” write-ups that I’ve previously posted  and more lengthy opinion pieces. I’ll try to update the blog every day, so keep checking in.

Blogging is a two way street — I write something, you comment. Or, you tell me something and I comment. To make this work, it’s imperative that I hear from readers. I welcome everyone to post their thoughts in the comments part of this blog, but more importantly, if you have a topic you’d like me to cover, or have an insider tip that I should know about, please get in touch at bryan.borzykowski@canadianbusiness.rogers.com.

Thanks and read on…

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Bryan Borzykowski is a senior editor at Canadian Business Online. Previously, he was the investments reporter at Advisor.ca and he’s contributed to a number of other publications including Maclean’s, Chatelaine and the National Post. His blog, Political Points, deals with the relationship between politics, business and the economy.

“Among the factors causing strains,” writes the author, “will be the fallout from unraveling economies and heightened resource constraints, waning U.S. power and global competition for influence … boundaries will shift and alliances will unravel, much like they did when the Communist Party was no longer able to exert its authority over the Union of Soviet Socialist Republics….”

A sign of a good book is that it gives the reader new perspectives and stimulates their thinking – even if they happen to disagree in whole, or part, with the author. Panzner’s latest book easily passes this test.

For example, I was intrigued by the questioning of the notion that foreign diversification is good for portfolios. This popular view might not deliver as well as expected when the world economy is contracting and protectionist measures are multiplying. “The “risks of investing … abroad will be far greater than in the past,” writes Panzner. During de-globalization, “countries will be less concerned about protecting foreigners’ rights ….”

Living in Canada, I got a kick out of reading that one of the few bright spots in the panorama of gloom was Canada. The country “seems to offer great promise as an investment destination. With its relatively stable history and political structure … rich deposits of hydrocarbons and other commodities, access to water, and arable land for farming, the country would seem to have a lot going for it.”

Major themes in the book include:

• a surge in protectionist measures and consequent prolongation of the economic contraction — in unison with other “second-order effects,”

• an extended retrenchment in the free-spending American consumer and firms catering to them,

• ever more perilous government finances that lead to cutbacks to government programs, hikes in tax burdens, forced conversions of investments into government bonds, and a resort in the U.S. to the printing press that may trigger “a hyperinflationary spiral,”

• general loss of confidence in U.S. dollar and other fiat currencies and concomitant rise in preference for precious metals as store of value,

• stocks and bonds will be undesirable asset classes; embrace commodities and resources

• threat of economic blackmail and loss of influence posed by vast reserves of U.S. dollars held by China and other countries

• continued slide in real estate prices, until 2012 at the earliest,

• suburbs to become a wasteland due to water and energy limits,

• rise in civil, regional, and international conflict

When Giants Fall: An Economic Roadmap for the end of the American era by Michael Panzner, John Wiley & Sons, 2009

The credit-rating agencies didn’t bray the fungus ball of securitized subprime mortgages because they wanted their fees. The SEC ignored Madoff whistleblowers because senior staffers didn’t want to jeopardize their chances for remunerative jobs with the firms they were overseeing.

This latest breakdown in the U.S. regulatory environment is a hump-backed whale compared to the minnows of Enron and WorldCom. Yet, little is being done about fixing the flaws as politicians rush to fork out trillions of dollars in bailout money.

Now would seem to be an ideal time for a politician of Spitzer’s ilk. Not only should some people spend time in front of a magistrate, but a new framework of rules and enforcement needs to be created alongside the rescue of the U.S. financial sector.

It’s encouraging to see Spitzer has started to write a policy column for Slate.com. That shows he is still interested in the body politic. Could re-entry into public life be far behind? I would welcome it (having previously lamented his departure from the scene). 

Incidentally, an endnote to one his columns reveals that the Spitzer family had an indirect investment with Bernie Madoff. It looks like they had deposited money with a fund that had invested assets with Madoff.